Page 135 - AFM Integrated Workbook STUDENT S18-J19

Risk adjusted WACC and adjusted present value

Using the existing WACC

2.1 When is the company’s existing WACC relevant?

 The existing company WACC should only be used as a discount rate for project
appraisal if:

– The project has the same level of business risk as the company

– The project is financed to keep the company gearing constant

– In effect, if the project looks like the company in miniature.

2.2 Further considerations

Some firms ignore the above issues and use the company WACC anyway. This is
usually justified as follows.

 The small project argument – a small project would not cause risk, k e, k d or
the WACC to change materially, so calculations are simplified by using the
existing WACC as a discount rate.

 The pool of finance argument – it may not be practical to use a mixture of
debt and equity for every project. Suppose for one particular project we use
debt finance, so the above table states that we should be using APV as the
gearing has changed. However, the firm could argue that next time it will use
equity and that in the long run gearing will be kept constant. This argument may
also be expressed as saying that rather than looking at the specific finance for
the project, we should consider the firm having a 'pool' of finance that gets
topped up.

123